"While cap-weighted indices measure many things, there is (at least) one important thing that they do not measure. The return of a cap-weighted index represents the performance of the average invested dollar, not the performance of the average stock. What is the average stock’s performance? The process of adding each stock’s return and dividing by the total number of stocks is precisely how the return of an equally-weighted index is calculated."

One important aspect of the white paper led to the discussion of "Active Share." Active Share has recently become a more popular topic as the variable provides investors with a data point to evaluate whether their active manager is really a closet indexer. Active share is essentially a measure that indicates by how much a particular portfolio differs from its representative benchmark. The importance of knowing whether your investment manager is employing a closet index strategy has to do with the fact that a closet indexing strategy is one that is difficult to outperform the market on an after fee basis. PIMCO released a white paper late last year, Active Share, Tracking Error and Manager Style, that provides a more indepth discussion on Active Share.

For more concentrated investment managers, one holding less than 50 securities, the PIMCO article notes managers with Active Share between 20%-60% would be characterized as having a low Active Share. Active Share over 90% would be considered high. At HORAN, our model portfolio holds 44 positions today with an Active Share of a little over 80%. The S&P 500 Index is our benchmark for our individual stocks, yet we have positions in eight stocks not represented in the S&P 500 Index. These eight positions account for 16.6% of our individual large cap equity weighting. Additionally, there are several larger S&P weighted positions we do not hold.

In conclusion, active share is only one measurement statistic investors can evaluate when comparing investment managers from one another. Just as a high Active Share can provide a manager with a greater likelihood to outperform their respective benchmark, it could also result in a greater likelihood to underperform. As noted in the PIMCO white paper, Active Share does affect idiosyncratic risk or that risk that can be mitigated by diversification. On the other hand, PIMCO notes there is no link between active share and systematic risk. Systematic risk is undiversifiable risk or market risk.

Wikinvest

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